How to Trade Derivatives in Stock Markets

Derivative is a product whose value is derived from the value of an underlying asset, in a contractual manner. The asset in question could be equity, forex, commodity, index or any other.

In India trading of derivatives is governed by the framework under the Securities Contracts (Regulation) Act, 1956.

Derivative products initially emerged as hedging devices against wild fluctuations in commodity prices, and commodity related derivatives remained the only form of products for almost three centuries. Post 1970 financial derivatives came into the scene due to growing instability in financial markets.

Futures is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Its standardized exchange traded contracts.

Options are premium based contracts which give the buyers right to buy (Call option) or right to sell (Put option) without any obligations to buy or sell a given quantity of the underlying asset at a given price on or before a given date.

DERIVATIVES TRADING INVOLVE A GREAT RISK AND REWARD

Derivatives were originally meant for hedging of the portfolio against wild fluctuations but gradually it became popular instrument of trading. Since these are leveraged product it involves a great risk of capital loss. Greater the leverage (Borrowing) greater is the risk and reward.

Let’s take a small example

Mr A has got a capital of Rs. 100000 and he buys a contract of Reliance having lot size of 250 shares @ Rs 1000 each.

Here total volume becomes Rs. 1000 x 250 = 250000

Assuming required margin to be deposited is 16%, therefore he needs to deposit Rs. 40,000

Now ,the capital utilized is 40 % and if the stock falls or rises by Re. 1 ,his account is affected by Rs. 250.

Assuming, the stock fell by Rs 100 and now trading at Rs. 900, he has to deposit another Rs. 25000 to maintain his position as Mark to market. Otherwise he may exit and book a loss.

The loss is 62.5 % of the capital utilized i.e. Rs 40000.

And a fall of Rs 160 or 16% of the stock could wipe out all the capital of Rs. 40000 and vice versa.

Options are like melting ice slabs, it keeps melting as time passes and becomes worthless on the day of expiry if its At –the- money or Out- of- money. ie the asset price closes at or below the strike price.

The greatest examples of financial disasters caused by reckless derivatives trading could be the collapse of Barings bank the United Kingdom’s oldest investment bank. It was caused by a single derivatives broker Nick leeson’s fraudulent and unauthorized speculative trading.

Recent economic crisis of 2008, bankruptcy of Lehman brothers and like are other examples.

According to Warren Buffet “Derivatives are WMD’s, weapons of mass destruction.”

Following are a few suggestions for traders who deal with derivatives trading.
a) Before getting into any trading understand your RISK, what is the maximum amount you may lose if things go wrong. If you do not have answers to this do not proceed.

b) Trading is like any other business, there is nothing like unlimited profits. Define your risk and expected reward.

c) Always follow stop losses and put in the system, without putting stop loss order is like driving without brakes.

d) Learn technical analysis for meaningful grasp of the price chart movements, its always better to learn driving before going to the busy roads rather than paying heavy fines.

e) Keep your losses small.

f) Always hedge yourself against overnight risks.

Though Derivatives involve a great risk of capital, but if handled with proper care and training can yield much larger returns. It is suitable for people having some risk appetite. One should preferably learn the ropes in detail before getting into trading them.

About the author

This article was posted by Jaswant Aditya Singh, a Technical trader and stock market trainer, on behalf of WinTheMarkets which provides various online Courses on Stock Market.